Feds Closer To Setting Up CDS Clearing Houses

Federal regulators are expected to release a memorandum of understanding as early as Friday outlining their plans to share information about the credit default swap market, according to a person close to the situation.

It is just the latest step in what has been a public and private effort to set up central clearing houses for the $34 trillion market. The source says regulators will not share oversight of this currently unregulated market, rather information about transactions and pricing.

It is unlikely there will be a single regulator to oversee the credit default swap market initially, the source said. Rather, regulators of the those approved to operate the clearing houses will monitor their constituents. Those regulators could include the US Commodity Futures Trading Commission, and the Federal Reserve and the Securities and Exchange Commission.

"A memoradum of understanding is in the works," said New York Federal Reserve spokesman Andrew Williams. He declined further comment on when it might be made public.

The central clearing houses are expected to be up and running sometime between the end of this month and December. Whether they will ultimately be overseen by a single regulator is up to Congress.

The goal of regulators and potential operators of the soon-to-be established central clearing houses is to increase transparency and reduce counterparty risk in the credit default swap market. Credit default swaps are basically insurance contracts on a bond or a loan that makes the buyers whole in the event the bond or loan defaults.

It is a market that has come under increased scrutiny in the last year, as credit default swaps written by insurer AIG played a role in the insurer's financial freefall, a freefall that required the government to save the firm.

AIG wrote CDSs on derivative products like collateralized debt obligations. In the early days of this business, AIG's former Triple A credit rating prevented it from having to post large amounts of collateral against the CDSs. Things changed though when AIG's credit rating was cut and the CDOs began to lose value. AIG was forced to post billions of dollars in collateral it did not have, in turn forcing the government to bail out the insurance giant.

Jamie Cawley, president of IDX Capital, an electronic interdealer broker of credit default swaps, says setttin up central clearing houses should help to prevent situations like AIG's from happening again.

For Investors

"By establishing the central clearing houses, if it is done correctly, there will be an honest recognition of capital allocation to every credit default swap contract that gets written," said Cawley. "That was certainly not the case in the past."

Cawley said a clearing house should act as an honest broker, marking its clients accounts to market every day and insuring they post the proper collateral every day.

"Just as what's done in the futures markets," Cawley said.

How It's Different

Right now a buyer of a credit default swap doesn't know if the seller has adequate capital to cover the contract in the event it defaults. A central clearing house insures that companies selling the CDS through its operation has the proper amount of money put aside, providing buyers of the CDS a measure of assurance the contract will be honored.

A number of groups have applied to serve as the central clearing houses. Those applications need to be approved by the applicants' regulators.

Among those applying to serve as a central clearing houses, the Chicago Mercantile Exchange. The CME joined forces with the Chicago-based hedge fund Citadel Investment Corporation, setting up an electronic trading platform the CME says is ready to go.

The CME, which trades futures and options on a variety of entities including commodities, currencies and interest rates, would provide the clearing entity, Citadel the trading technology. They have also invited major players in the CDS market to join them in the venture. The CME's regulator is the CFTC.

The Intercontintental Exchange (ICE), an electronic commodities exchange, also threw its hat in the ring. Its partners include The Clearing Corporation, Markit Group, and Risk Metrics. ICE is applying for a New York State banking license, which if approved, would mean it's chief regulator would be the Federal Reserve.

Others vying for a piece of clearing business for CDSs include the New York Stock Exchange and Eurex, a clearing house owned by the Deutsche bourse.

Establishing central clearing houses for credit default swaps could mean billions in lost revenue for the big dealers in the market, like Deutsche Bank , JPMorgan , Morgan Stanley and Goldman Sachs . Currently they get fees for matching buyers and sellers of the credit default swaps. A central clearing house would diminish the need for their services.